So, you are an entrepreneur considering seeking investment via new Rule 506(c), very exciting! I’m sure you have all types of things running through your mind: pitch decks, projections, and where you will spend that sweet, sweet investment cash (equipment, labor, and marketing I’m sure). However, there are some other, more mundane things you should really think about before you dip your toe in those waters, because when a company seeks investment a lot of the little things that might never come up otherwise become critically important.
This article is the first in a series about what you need to do to get ready to seek investment online, and like all the best things it starts with a disclaimer: This is not legal advice; please speak with your attorney about your unique situation. With that out of the way lets sit down, strap in, and get ready to talk about the corporate form.
If you are going to seek investment you are going to have to be a corporation, and not just any type of corporation either. This may seem obvious to many of you but we should remember that millions of people conduct business without a corporation, either as part of a partnership or as a sole proprietorship. While there may be good reasons to adopt one of these structures to run your business they are incompatible with seeking investment, so if seeking investment is something you want to do, you will need to become a corporation (or if you are a corporation, decide if your current form is the right one).
The unique feature of a corporation suitable for seeking investment is that you can sell an interest in the corporation to a person who isn’t involved in the business itself. Its hard to have more than one person in a sole proprietorship, and partners generally need to take an active role in the business, while with a corporation you can own part of the company without being part of the company. This is a pretty important feature if you are considering taking money from people all over the world, unless you want to have a bunch of new partners and hope they know how to help run your business.
It is at this point that I should take an aside and explain the corporations are creatures of law, and specifically the law of the state you incorporated in (which isn’t necessarily the same state you live or do business in). While this piece will mention in very (very) general terms about the possible advantages and disadvantages of types of corporations it is important to remember that your situation may vary based on the specific law you are dealing with. You should look at your unique situation and talk to your lawyer before making decisions.
Ok, where were we? Corporations. Now you will need to decide what type of corporation you want to be. The three most popular types are “C” corporations, “S” corporations, and Limited Liability Companies, otherwise known as “LLCs”.
S corporations are basically pass-through entities that allow for the passage of income, loss, deductions, etc. directly to the shareholders for the purposes of avoiding double-taxation. They are probably not a good fit for a company seeking online investment since the tend to have a low limit for the number of shareholders allowed (the IRS caps it at 100) and can only issue one class of stock, which would mean your investors would have the same rights you do. Those are just the IRS rules; your state may have additional restrictions. If that works for you, go for it, but for many companies intending to grow, those restrictions (as well as other limitations inherent in the S corp.) will cause them to look elsewhere, which brings us to the…
LLC! The LLC is a relatively recent but highly used corporate form that allows for favorable tax treatment and a lot of customization as to how the business is structured. However, as my colleague Andrew points out, there are certain problems with the LLC that can make it sub-optimal for a company seeking broad-based investment. If you are an LLC and want to stay an LLC, you can make it work, but it will be work. If you are looking for something more “off the rack” friendly to seeking investment maybe you should consider a…
C corp! The C corp. is the quintessential corporate form for the company that wants outside investment. Unlimited number of investors? Check! Different classes of shares (and therefore the ability to limit the rights of certain shareholders)? Check! Management protections from meddling shareholders? Check (again, subject to the unique rules of your state of incorporation)! While the C corp. may be less than ideal in other areas like tax treatment, it provides considerable inherent flexibility in terms of seeking and managing investment, which it is so popular with large public companies.
This isn’t a complete list of course; your state may have other options, such as the new “B corporation.” The point is that before you seek investment you should look at the strengths and weaknesses of each type and decide what works best for your business, not only in terms of seeking investment but also in terms of your day-to-day operations. Once you have figured that out you will be ready for the next step, actually incorporating, but that is a topic for another blog post.